Editor's Note: As the campaign to rectify the "invoicing economy" continues to deepen, fictitious trade and circular invoicing have become key targets of tax authorities' investigations. Because of their sound credit standing and strong financing capacity, local state-owned enterprises (SOEs) are often embedded in financing-oriented circular trade arrangements. Once the authenticity of the transactions is denied, they fall into the tax dilemma of "fictitious input and fictitious output". Taking as its starting point the circular live-hog trading case recently exposed by the State Taxation Administration (STA), and drawing on a practical case in which an SOE was subjected to tax treatment and penalties for participating in circular trade, this article analyzes the unreasonable tax burden resulting from the current treatment approach. Proceeding from the original intent of the rules on recovering tax on falsely issued invoices and from the principles of value-added tax (VAT), it explores the appropriate tax treatment of fictitious input and fictitious output.

01 Behind Live-Hog Purchases and Sales Invoiced at Nearly RMB 8.8 Billion Lies a Fictitious Trade Loop

On October 19, the State Taxation Administration published three tax-related cases concerning the rectification of the "invoicing economy". In one of them, Guangxi Nanning Xuanpeng Agricultural Development Co., Ltd. ("Xuanpeng"), between 2023 and 2025, used false qualifications to obtain live-hog purchase and sale business from multiple local SOEs. Relying on the "endorsement" of contracts with the SOEs and on means such as the misappropriation of slaughter certificates, it fraudulently obtained quotas for fully digitalized electronic invoices and issued invoices totaling nearly RMB 8.8 billion. The vast majority of these purchase and sale transactions were fictitious live-hog trades. The investigation found that the live hogs were sold by Xuanpeng to the local SOEs, resold by the SOEs to Guangxi Yipindan Food Co., Ltd. ("Yipindan"), which was actually controlled by Xuanpeng, and then sold back by Yipindan to Xuanpeng, forming a fictitious trade loop. Xuanpeng also induced the SOEs to take out bank loans to prepay for goods and diverted the funds to other uses. After its actual controller fled abroad, several SOEs were unable to recover huge sums, with the loss of one of them alone reaching as much as RMB 60 million.

The official notice focuses on Xuanpeng. Viewed from the SOEs' side, however, the loop could operate precisely because of the SOEs' credit standing and financing capacity. The SOEs' purchase and sale contracts became the "endorsement" Xuanpeng used to fraudulently obtain invoice quotas, and the SOEs' bank loans became the source of the funds the other party diverted. In practice, some SOEs participating in such business are deceived, while others participate knowingly in order to boost revenue and gain financing convenience. Circumstances also vary from transaction to transaction: some involve no goods at all from the outset, while in others genuine goods do flow through certain links. For transactions without any genuine goods, from a tax-law perspective, there is no genuine purchase-and-sale relationship between the SOE and its upstream or downstream counterparties. The payments made by the SOE are not consideration for goods, and regardless of whether they can later be recovered through civil litigation or the recovery of illicit proceeds in criminal proceedings, this does not change the fact that, for tax purposes, no genuine purchase took place. The question that arises is whether the input VAT the SOE has previously credited must be reversed and repaid, and how the output VAT it declared when issuing invoices to downstream parties should be treated.

02 The Treatment Approach of Reversing Input VAT Without Adjusting Output VAT Traps SOEs in a Back-Tax Dilemma

This problem has already materialized for some SOEs. A certain local SOE, under pressure in its core business, participated several years ago, through a subsidiary, in a set of bulk-commodity trades in order to expand its revenue and facilitate financing. It purchased from upstream and resold downstream; contracts, invoices and funds were all in place among the parties, yet no goods were actually delivered. After the downstream party defaulted on payment, the SOE sued to recover the money, but the court held that the transactions had been jointly fabricated by the parties and did not constitute an ordinary civil dispute. The tax authority subsequently conducted an inspection and determined that the relevant invoices had been falsely issued. It required the SOE to reverse and repay all the input VAT it had credited, imposed a late-payment surcharge, and also levied a fine, the total amounting to tens of millions of yuan. However, the tax authority made no adjustment to the output VAT the SOE had already declared when issuing invoices to the downstream party.

The basis for this treatment was the Announcement of the State Taxation Administration on Issues Concerning the Collection and Recovery of Tax on Special VAT Invoices Falsely Issued by Taxpayers (STA Announcement No. 33 of 2012). The Announcement provides that "where a taxpayer falsely issues special VAT invoices and has not declared and paid VAT on the falsely invoiced amount, it shall pay VAT on the falsely invoiced amount; where it has declared and paid VAT on the falsely invoiced amount, it shall no longer pay VAT on the falsely invoiced amount", and that "special VAT invoices falsely issued and obtained by a taxpayer shall not be used as legal and valid VAT credit vouchers to credit its input VAT". Accordingly, the output VAT declared by the SOE as the invoice issuer was retained, while the input VAT it had credited as the invoice recipient had to be reversed in full.

This is precisely where the problem lies. In its original returns, the SOE offset the output VAT on the invoices it issued with the input VAT on the invoices it received, and actually paid only the tax corresponding to the thin price margin between the two. Once the input VAT is reversed while the output VAT is left unadjusted, the SOE in effect bears VAT equal to the full output VAT on a sale that never existed. Even if the SOE was genuinely deceived, it can hardly rely on the bona fide receipt rule to escape this predicament, because under Guo Shui Fa [2000] No. 187, bona fide receipt presupposes a genuine transaction between buyer and seller. Since the transaction itself never existed, whether the tax treatment should be restored to the state as if the transaction had never occurred is the question of greatest concern to such enterprises.

03 Fictitious Input and Output Should Be Offset Simultaneously, With No Need to Repay Input VAT

Answering this question requires returning to the original intent of STA Announcement No. 33 of 2012 and to VAT principles. The crux of the current approach is that it mechanically applies, in combination, two rules of the Announcement that target the invoice issuer and the invoice recipient respectively to one and the same entity engaged in fictitious input and fictitious output.

When Announcement No. 33 took effect, it repealed Article 2 of Guo Shui Fa [1995] No. 192, which provided that "for special VAT invoices falsely issued or issued on behalf of others by taxpayers, tax shall in all cases be collected or recovered in full at the rate applicable to the goods listed on the face of the invoice". According to the STA's interpretation of the Announcement, the original rule was formulated in the era of handwritten invoices, when problems such as "big head, small tail" (the copy given to the recipient showing a larger amount than the copy retained by the issuer) were prominent, with issuers under-declaring and recipients over-crediting, so that full collection and recovery based on the invoice face was consistent with the tax administration realities of the time. After the anti-counterfeiting tax control system was fully rolled out, issuers had generally already declared and paid tax on the invoiced amounts, and further full collection based on the invoice face would amount to levying the same tax twice. Announcement No. 33 therefore provides that no further payment is required where tax has already been declared and paid. It follows that the Announcement was adjusted in the direction of narrowing the scope of recovery and avoiding double taxation, not of imposing additional tax on falsely issued invoices.

From the standpoint of VAT principles, under Article 3 and other provisions of the Value-Added Tax Law, a tax liability presupposes a taxable transaction such as the sale of goods within China; without a transfer of ownership of goods, no statutory tax liability arises. The tax borne by a false invoice issuer by virtue of issuing invoices is, in substance, a deemed tax liability, and Announcement No. 33, as a normative document, cannot override superior law by equating it with a statutory tax liability. With respect to one and the same fact, namely that the transaction is not genuine, the tax-law assessment should be consistent: if that fact is relied upon to deny the input VAT credit, it should equally be relied upon to deny the output VAT liability.

Judicial practice also recognizes this logic. In Case (2019) Jing 02 Xing Zhong No. 113, Hehui Weiye Trading (Beijing) Co., Ltd. ("Hehui Weiye") issued output invoices without any goods in order to facilitate trade financing, and also obtained falsely issued input invoices to credit against them. In its judgment, the Beijing No. 2 Intermediate People's Court stated that "the levying of VAT is factually premised on an actual flow of goods or the occurrence of taxable services and on value being added", and that the output invoices issued by Hehui Weiye, "because no actual flow of goods occurred and no genuine value was added to goods, lack a factual basis for paying VAT, and not paying that portion of tax would not cause any actual tax loss to the State". On that basis, the court held that the evidence was insufficient to establish that crediting the falsely issued input invoices against such output invoices had caused a tax loss. Although this judgment is a criminal ruling, it is equally instructive for how fictitious input and fictitious output should be treated in administrative proceedings.

Accordingly, the reasonable treatment of fictitious input and fictitious output is for the tax authority, in the same proceeding in which the input VAT is reversed, to reduce the corresponding output VAT as well, so that the tax payable as a result of reversing the input VAT is offset against the corresponding output VAT. After such treatment, the fictitious transactions in effect no longer generate any additional tax burden, and the SOE therefore need not repay the input VAT. Conversely, where every link has declared output VAT and credited input VAT, if every enterprise in the chain is required to reverse its input VAT and pay back tax while its output VAT remains unadjusted, a transaction in which goods never appeared will be taxed separately at each link. The longer the chain, the greater the total back tax, far exceeding the VAT the whole chain would have owed had the transactions actually taken place. Since Announcement No. 33 corrected even the double levying of the same tax amount, it should all the more not serve as a basis for taxing a nonexistent transaction link by link. This does not, of course, mean that false invoicing can go unpunished. Issuing invoices without a genuine transaction constitutes false invoicing under the Measures for the Administration of Invoices, and the tax authority may impose administrative penalties according to law, but this should not be converted into recovering tax on a transaction that never existed.

The current approach also objectively dampens enterprises' willingness to correct themselves voluntarily. Once an enterprise voluntarily discloses that its transactions were not genuine, it must repay the input VAT in full together with the late-payment surcharge. Enterprises that come forward thus pay the price of their entire input VAT, while those that stay silent may "get away unscathed". This is inconsistent with the aim of the campaign to rectify the "invoicing economy", which is to guide enterprises to rectify problems on their own initiative.

04 Conclusion

As the rectification of the "invoicing economy" deepens, similar cases will increase and the risks faced by SOEs will grow accordingly. In April this year, the STA issued the Positive and Negative Lists for Taxpayers' Compliant Issuance of Invoices, which place on the negative list such circumstances as engaging in financing-oriented trade or fictitious trade, the backflow of funds through related-party accounts after payment, inconsistency among the "four flows" (contracts, goods or services, funds and invoices), reciprocal and circular invoicing without a reasonable commercial purpose, and "idle circulation of documents" through fictitious transaction links. Circular trade with no genuine transactions upstream or downstream often falls under several of these items at once, so the risk of being identified and characterized is very high.

In response, SOEs should conduct self-inspections of their existing trading business, checking whether upstream and downstream parties are related, whether transfer-of-title and logistics documents corroborate the invoices, and whether funds flow back within the chain, and distinguishing circular transactions that involved no goods from the outset from business in which genuine goods flowed. Once transactions are determined not to be genuine, the input VAT may be required to be reversed in full. Enterprises should therefore actively present their views at the tax inspection stage and, relying on the original intent of Announcement No. 33 and VAT principles, argue for the simultaneous offsetting of input and output VAT. Enterprises are advised to engage professional tax lawyers as early as possible to safeguard their lawful rights and interests at every stage, including tax inspection, administrative reconsideration and litigation.